NHS pensions and the annual allowance

The tax implications of your NHS pension contributions

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What is the annual allowance?

The annual allowance was introduced back in 2006, designed to prevent the wealthiest people from taking advantage of excessive pension tax relief. The limit was originally set at £215,000.

Since its introduction, the annual allowance has been adjusted many times by successive governments. By 2014, it had dropped to £40,000 - where it has remained ever since.

This means that unless you have ‘carry forward’ available, you can currently only save £40,000 a year into a pension before you’re potentially hit with a tax charge of up to 45%. For high-earning doctors, that threshold may be lowered further under the tapered annual allowance.

What is the tapered annual allowance?

The tapered annual allowance further restricts the amount of pension tax relief available for high earners, reducing the annual allowance to as little as £4,000 for some people. It applies to those with an ‘adjusted income’ (we’ll explain that shortly) of £240,000 or more.

For every £2 of adjusted income over that £240,000 limit, your regular £40,000 annual allowance is reduced by £1. For example, if your adjusted income is £260,000, your annual allowance would shrink to £30,000.

However, if your adjusted income exceeds £300,000, a flat rate annual allowance of just £4,000 applies.

Your adjusted income
Your annual allowance
Up to £240,000
£40,000
£250,000
£35,000
£260,000
£30,000
£270,000
£25,000
£280,000
£20,000
£290,000
£15,000
£300,000 and above
£4,000

For the highest earners in the NHS Pension Scheme, the tapered annual allowance can feel like a punishment for their many years of service. However, when the rules were first introduced, tapering began at an adjusted income of just £150,000 – so things have at least improved for the vast majority.

Calculating adjusted income

There are two definitions of income for tapered annual allowance purposes - 'threshold income' and 'adjusted income'. Simply put, threshold income is your gross income minus your pension contributions (employer contributions don’t count).

For example, if you have a salary of £120,000 and your NHS employee contributions are £17,400, your threshold income (assuming you have no other tax-relievable payments) would be £102,600.

Bear in mind though, threshold income isn’t just about your NHS earnings. Any other income you receive from other sources – be it dividends from investments or rental income from a second property – would form part of your threshold income too.

Adjusted income is effectively your threshold income plus the value of your pension savings. So, to build on the previous example, if your pension input for the year was valued at £50,000, your adjusted income would be £102,600 + £50,000 = £152,600.

By calculating your own threshold and adjusted incomes, you’ll be able to see whether you’re entitled to the full standard annual allowance, or whether you’re affected by the taper:

  • If your threshold income is under £200,000, you’ll get the full standard annual allowance regardless of your adjusted income.
  • If your threshold income is above £200,000 but your adjusted income is below £240,000, you’ll get the full standard annual allowance.
  • If your threshold income is above £200,000 and your adjusted income is above £240,000, your annual allowance will be reduced under the tapered annual allowance.

Of course, incomes and pension values can change all the time, so it can be hard to keep track of your position in regard to the annual allowance. If you’re in any doubt and need professional advice, why not speak to a Specialist Financial Adviser from Wesleyan Financial Services – experts in the NHS Pension Scheme.

How and why doctors are affected by the annual allowance

The NHS Pension Scheme is a defined benefit scheme, where the value of the final benefits doesn’t depend on investment returns but a percentage of the pensionable pay. The value placed on this type of pension scheme is extremely high.

The combination of high-value pension and sizeable salary means doctors get caught more often than any other working group.

What’s more, the nature of a defined benefit scheme means contributions are fixed to a certain rate, linked to salary. So, members of the NHS pension can’t simply choose to lower their pension contributions to manage the annual allowance.

What it’s meant for doctors

These factors have historically resulted in many doctors paying higher amounts of tax for the privilege of remaining in the NHS Pension Scheme. Prior to the raising of the tapered allowance threshold, many chose to leave the scheme altogether.

Although the changes to the tapered allowance limit have improved the situation for most people, the £40,000 annual allowance threshold remains a challenge in itself. Meanwhile, many doctors who left the NHS Pension Scheme are now choosing to return – leaving a number of retirement queries around what happens when you take a break from the NHS pension?

Ways to avoid or prepare for a breach of the annual allowance

The first step towards planning for the annual allowance is to calculate your entitlement, and check whether you’re eligible for the full £40,000 tax allowance or not. To help you do this, you can ask the NHS Pension Scheme for a pension saving statement, which shows the amount saved into a pension over previous tax years.

If you think you may be impacted, talk to a Specialist Financial Adviser who understands the NHS Pension Scheme. They will help you work out your adjusted income by looking at all your pension contributions and your pension growth, advising you on any available options to limit your liability.

Carry forward

For instance, you may have some available ‘carry forward’ capacity. The carry forward facility allows you to roll-over unused allowances from the previous three years – so if you’ve only just started maxing out your allowance, there’s every chance you may be able to take advantage.

Theoretically, if you hadn’t paid into a pension at all over the previous three years, that’s up to £40,000 per year you can roll forward. Added to your allowance for the current tax year, that could allow you to save up to £160,000 into your pension in a single year, without being hit by tax. 

Other options

Even if you don’t have any carry-forward capacity, a financial adviser will be able to help you assess your pension position. If you are contributing to a separate personal pension plan, or perhaps paying additional voluntary contributions for Added Years or Additional Pension under the NHS scheme, it’s worth considering whether these remain suitable for you.

It’s also sensible to build a healthy cash reserve, allowing you to deal with any tax charges that come your way if you can’t avoid exceeding the allowance.

What happens if you exceed the annual allowance?

If you exceed the annual allowance, your excess pension savings will be taxed at your highest tax rate. As an additional-rate tax payer this will be 45%.

As an example, if your annual allowance was reduced to £20,000 due to tapering, but you save £40,000 into your pension, you’d pay 45% tax on the excess £20,000 – a bill of £9,000.

If you do receive a bill, there are options available as to how you pay it. You can pay out of your own savings, or you can choose the option of ‘Scheme Pays’.

Scheme Pays is an initiative whereby you can ask the NHS Pension Scheme to pay your annual allowance tax charge. Effectively, this is a loan which you pay back, with interest, when you retire. The amount you owe will ultimately be debited from your NHS pension benefits, reducing your final retirement income.

It won't be the right option for everyone. Some members of the NHS Pension Scheme – particularly those with some time to go until retirement - might be better off paying the annual allowance charges themselves if they can afford it. This allows you to continue taking your full pension benefits when you retire.

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